Growing up, the GEICO Gecko and Allstate’s Mayhem were frequent fixtures of TV nights with my family. “15 minutes could save you 15% or more on car insurance” and “You’re in good hands” were slogans I knew for as long as I could remember. Clearly, the services these companies were selling – different types of insurance – were marketed as taking care of consumers in a valuable way. Yet, for many individuals including myself, insurance was an ambiguous and poorly understood concept. In this blog post, I will demystify the basic role of insurance and discuss common threats to insurance markets (e.g., adverse selection and moral hazard).
The basic role of insurance
It is no secret that life can be unpredictable. At its core, insurance is a mechanism to reduce uncertainty, hedge against unpredictable losses, and pool risk. Insurance programs exist in countless domains – auto, home, life, etc. – but this post will illustrate key concepts of insurance markets by talking about health insurance in particular. Given our inherent urge to live long and healthy lives, mechanisms like insurance that mitigate the losses from unforeseen health events are powerful and in some cases life-saving.
Consider the example of Mr. A, a 50-year-old gentleman who, on a routine visit to a doctor, is found to have evidence of a condition for which diagnosis and treatment will cost him $100,000 over the next 3 months. With Mr. A’s $50,000/year-salary job and household of four to take care of, such an out-of-pocket expense would be catastrophic. Insurance markets seek to address this issue at the societal level by having individuals pay a lower, fixed cost with certainty to avoid a higher, potentially debilitating cost with uncertainty. More concretely, say a population of 1,000 individuals each pay $1,000 upfront (i.e., a fee known as a premium) for a health insurance plan; the insurer can then pool the $1,000,000 in premiums to offer benefits and cover services – either partially or in full – for individuals like Mr. A to alleviate uncertain financial hardship.
For insurance markets to operate efficiently in an economic sense, insurers offering insurance plans and individuals purchasing those plans would ideally have access to the same information. However, health care is a setting rife with information asymmetries. Individuals, for example, know more about their current and likely short-term future health status than insurers, while insurers may have access to more population-level data informing the services they choose to cover vs. not cover. In the sections that follow, I will talk about two potential threats to health insurance markets, both of which can arise from asymmetries in information.
Adverse selection in health insurance markets may occur as a result of individuals having more knowledge about their health status than insurers. Recall our friend Mr. A, who is now aware that he will incur at least $100,000 in medical expenses over the coming year. Now, imagine we have another patient, Ms. B, a healthy, 25-year-old young woman with no medical conditions and good health habits. Faced with a $1,000-premium health insurance plan, who would be quick to purchase the plan and who might be quicker to skirt it? Naturally, Mr. A would value the cost-savings, while Ms. B might view insurance as an unnecessary expense.
If such decisions were made by individuals at the population level, insurance plans would start to look less representative of the population as a whole and dominated by sicker, more medically expensive individuals. In response, to maintain their financial stability, insurance companies might raise their premiums. This may drive additional healthier individuals out of the plan, leading to spiraling costs and increasingly unaffordable prices. At some point, the entire insurance market will fail. A sustainable insurance market necessitates having individuals who are both low risk and high risk, with lower risk individuals paying into a system that helps alleviate burdens for those who are higher risk.
Another type of information asymmetry can also occur in health insurance markets. Consider Mr. A again: what if Mr. A decides that in the presence of health insurance, he will more liberally seek health care services, since he will no longer bear the financial consequences of such a decision. In fact, it will help him to stay hyper-vigilant about his health going forward, he thinks. If there is information asymmetry such that an insurer does not anticipate this behavior, the insurance company will be at a relative disadvantage. All of a sudden, the insurer will have to pay a higher fraction of medical claims, driving an increase in premiums to maintain financial sustainability. To the extent that this issue is widespread and adverse selection is also at play, the health insurance market may eventually fail.
In sum, insurance can be an invaluable instrument to mitigate uncertainty and pool risk at a population level. However, threats to insurance plans like adverse selection and moral hazard must be anticipated and stemmed. In a subsequent post, I will dive into recent strategies that have emerged in the U.S. to mitigate such threats and ensure health insurance markets function more effectively.